Understanding Inventory Turnover Ratio

Inventory Turnover Ratio indicates how efficiently a company manages its inventory and how quickly it is converted into sales. In other words, it shows how many times a company has sold its inventory and replaced it in a given period. It is calculated as the cost of goods sold divided by average inventory. Inventory Turnover Ratio is also known as 'Stock Turnover Ratio' and 'Stock Velocity Ratio'.

The formula to derive Inventory Turnover Ratio



Cost of Goods Sold - COGS is the direct cost of producing the goods or inventories sold by the company. It includes the costs such as the cost of raw materials, direct labor costs, etc. The formula to calculate the Cost of Goods Sold is ( Starting Inventory + Purchases - Ending Inventories).

Average Inventory - It is the average amount of inventory over two or more accounting periods, or it is inventory available in stock over a specific period. The formula to calculate Average Inventory is (Beginning Inventory + Ending Inventory / 2).

Example of Inventory Turnover Ratio: For the financial year, Bajaj Auto limited reported the cost of goods sold as Rs. 19597.38 Cr. and average inventory as Rs. 1278.70 Cr.
The value as per the formula (Cost of Goods Sold / Average Inventory) is calculated as (19597.38 / 1278.70) = 15.33.

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Key Highlights

The inventory turnover ratio is calculated as the cost of goods sold divided by average inventory.

Inventory Turnover Ratio is also known as Stock Turnover Ratio and Stock Velocity Ratio.

The high inventory turnover ratio indicates that the company manages its inventory efficiently and sells it quickly.

A low inventory ratio indicates that the business is not doing well or spends more money on inventory but is unable to generate sales.

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While looking at the Inventory Turnover Ratio, the following points should also take into consideration:

A high inventory ratio is considered good. It indicates that the company is efficient in managing its inventory and selling it quickly. In other words, it shows the strong sales of the company.

Generally, a high inventory ratio is considered good. But investors must check the factors behind it. Because in some scenarios, a high ratio can be due to insufficient inventory on hand. In other words, the company may be losing out on potential sales.

A low inventory ratio indicates that the business is not doing well or spends more money on inventory but is unable to generate sales, indicating a low rate of inventory turnover. A low ratio also indicates too much inventory in stock.

It shows how many times a company has sold its inventory and replaced it in a given period. If the company's inventory turnover ratio is five, then it indicates that the company has sold off its inventories five times in a period.

By dividing the 365 days by inventory turnover ratio, we get the value of inventory days that indicates how many days it takes for a company to convert its inventory into sales.

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How to use Inventory Turnover Ratio effectively

Investors should look for a higher ratio. It indicates that the company is managing its inventories well and generating sales.

There is no ideal inventory ratio as it differs from industry to industry. The inventory turnover ratio of the FMCG will be much higher compared to the automobiles industry. So, compare companies that operate in the same industry.

For a better analysis of the company, investors should look at its historical data to understand the past performance of the company, and while doing analysis, we cannot depend on one particular metric, hence look at other financial metrics with inventory turnover ratio such as Inventory Days, Days in Working Capital, Account Receivable Turnover Ratio, etc.,

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